In Cyprus Rescue, Germany Forged New Vision for Bank Union

With few exceptions, senior European policy makers agree that the euro zone needs a "banking union" to correct flaws in its makeup that have been laid bare by the region's financial crisis. Trouble is, they don't agree what "banking union" means.

Most academics suggest the banking union requires three pillars: a single euro-zone bank supervisor; a single "resolution authority" to deal with failing banks; and a single safety net to protect small depositors. These three elements are necessary, they argue, to deal with two glaring weaknesses that have threatened the euro zone's financial stability.

In the first, people lose confidence in shaky banks because they doubt that their government's finances are strong enough to rescue the banks. At the same time, anxieties about feeble banks undermine confidence in government finances.

The second weakness is that national bank supervisors get too close to the institutions they are supposed to be policing, and treat them too leniently, to the detriment of taxpayers and sometimes other countries that also suffer when a big bank fails.

A euro-zone supervisor, a separate authority to make sure the taxpayer isn't inevitably on the hook when banks are wound down, and a credible euro-zone-wide deposit-guarantee program to stop destabilizing deposit flight are all widely viewed as necessary to resolve these weaknesses.

The first element of this plan advanced on Thursday, when European Union ambassadors agreed on details of the new single supervisor to come into being next year. Irish Finance Minister Michael Noonan—whose country is taking the lead on the negotiations because it occupies the six-month revolving EU presidency—said: "We need to build on this momentum to make progress on the next building blocks: bank resolution and deposit guarantees."

Yet, for some in the euro zone, the banking union needs only two pillars. In an interview this week with The Wall Street Journal, Jens Weidmann, the head of the Bundesbank, said: "For me, the banking union consists of two pillars. One is the single supervisory mechanism and the other one is the resolution mechanism. So ideally they should be established together."

Mr. Weidmann is not a lone voice. Germany's leaders are nervous about committing their country to large-scale financial transfers to other countries in any circumstances. But they are especially worried about the consequences of a euro-zone deposit-guarantee program given that euro-zone banks hold close to €11 trillion ($14.334 trillion) of deposits.

Yet, for some experts, last month's bailout agreement for Cyprus showed that some common deposit-guarantee arrangement is essential. Big depositors in the country's two biggest banks lost money and the island remains financially cut off from the rest of the euro zone because of capital controls intended to stop deposit flight. As things stand, the EU requirement that all governments guarantee deposits up to €100,000 rests on the troubled shoulders of the Cypriot government.

"Cyprus has made it more difficult to argue with a straight face that deposit insurance is not needed for the euro-zone banking system on a steady-state basis," said Nicolas Véron of the Brussels-based think tank Bruegel.

Berlin is also suggesting it wants to go slow even on a resolution authority. "If we want European institutions there," German Finance Minister Wolfgang Schäuble told reporters last Saturday, "we need treaty changes." While many, including the European Commission, disagree on whether changes in EU treaties would be needed to take such a step, changing the EU's basic law is an uncertain and time-consuming process that would take years to complete.

The question then is how does Germany, whose leader declared in June along with other euro-area leaders that "it is imperative to break the vicious circle between banks and sovereigns," propose to break that circle?

In June, most European leaders appeared to have understood that they would, as a last resort, allow their common bailout fund to step in directly to save ailing banks, thereby cutting out the need for national governments to do so.

The German preference seems to be that the link should be broken in a different fashion. First, make sure banks are in good shape before the new euro-zone supervisor begins policing them. That will require banks to undergo a tough asset-quality review and to boost their capital if necessary.

That should sharply reduce the risk of bank failure. But, if a bank subsequently has to be wound down and national governments can't afford to save it, tough Cyprus-style bank "bail-in" procedures would force losses on bank creditors, large depositors or both. The risk of euro-zone funds being needed under those circumstances would be small.

And a deposit-guarantee plan for the euro zone? That's not needed because the euro zone's small banks are mainly funded by insured small depositors, and their deposits could easily be guaranteed even by a cash-strapped national government. Bigger banks, meanwhile, have a larger proportion of big uninsured depositors and creditors available for "haircuts," allowing small depositors to be spared.

Many financial specialists agree that reducing implicit taxpayer support for banks would force investors, large depositors and bank executives to take greater care over what they do with their money.

But, with the crisis far from over, they question whether now is the right time to explain to investors and large bank depositors in the euro zone that their investments have just got riskier.

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